Most, including us, correctly anticipated that 2018 would bare scant resemblance to the serene stock market windfalls of 2017. Many, again including us, even correctly pinpointed some of the sources of returning market volatility – fears of rising inflationary pressure, a messy unwind in the short-volatility trade and trade protectionism. The twists and turns of the first quarter have proved unsettling all the same. The consensus on stock markets has (thankfully) started to fracture as a result. The rapidly evolving trade spat has persuaded many to seek solace in the arms of a less prohibitively priced bond market. Is this apparently fractious geopolitical backdrop finally set to overwhelm a still positive global economic context for capital markets?
The last month has seen this US administration’s bite appear to match up to the protectionist barks of the campaign trail. Tariffs are certainly not welcome and the threat these trade tensions develop into something more economically damaging has certainly grown over the last couple of weeks. However, the tariffs announced and threatened so far by both sides represent a more or less insignificant headwind to global growth (China’s global exports came to $2.2trn in 2017 and US imports from the rest of the world were $1.8trn). It is still the threat that words turn into further deeds that is preoccupying investors.
Our suspicion remains that the threats to date represent a negotiating tactic on the part of the US administration, essentially a game of chicken, aimed at further prizing open what remains the most protectionist of the world’s major economies. President Trump will be looking for a big win to wave to the electorate well before the midterm elections in November. In such a context, China cannot afford to look weak, which perhaps helps explain the near instantaneous, proportionate and politically spiced response to the US tariff list. The map of US soybean production chimes nicely with the map of states that turned for Candidate Trump in the last election.
Our base case therefore remains that negotiation and de-escalation will be the likely endgame. Nonetheless, China's proportionate response has increased the risks of further escalation in "rhetoric" in the coming weeks, which will no doubt keep the markets jumpy.
With 14 of the lowest ever 20 closes on the VIX’s 28-year history occurring in 2017, it’s safe to say that last year was an outlier in terms of volatility. The behaviour of markets so far this year represents a jarring return to normality. There are nonetheless a number of points to draw from this returning market chop in the first quarter. First and most obviously – the reminder to would be short-volatility investors is that they are getting paid for insuring against volatility. Here, insurance provision is a negatively skewed trade – premiums role in month after month until the event you are receiving premiums for occurs and a sharp loss ensues. Given the prolonged period of subdued market volatility in the run up to February’s rout, it may be that some of the investors in the now infamous short volatility products had forgotten exactly what they were receiving payment for.
More broadly, greater volatility should bring with it a wider opportunity set for active managers. This is when they should, in theory, earn their fees relative to the ever widening array of passive products. However, the day-to-day swings in stock markets should also serve as a healthy reminder of the need for humility in investors and forecasters. As noted above, many correctly identified a less accommodating bond market as a source of potential market angst this year, but pinpointing when this fixed income correction might impinge on stocks and how the story would evolve more precisely (and usefully) of course proved more elusive. Similarly, a trade war has been the main concern for investors since candidate Trump’s chaotically abrasive election campaign. Those who decided to stay on the sidelines from Election Day as a result have missed out on meaty stock market returns amidst accelerating global economic growth. Our focus as investors is still more reliably spent on scrutinising the underlying prospects for the economy rather than the various characters presiding over it. To this end, the prospects for economic and therefore profits growth have us continuing to side with stocks on a tactical time frame in spite of the prospect of more volatility amidst the tough talk on trade.
The return of inflation
The first signs of volatility this year occurred in late January. US markets started to correct in response to a positive surprise in the US wage data, something widely interpreted as a signal of rising inflation, higher rates, and therefore, lower equity valuations. Back then, we cautioned against reading too much into a single monthly data point – the January surprise came from a minority subset of the sampled workforce, whose wage growth tends to be volatile anyway. Excluding this group, gains were more muted. Indeed, investor focus switched to other concerns as the moderate trend in wage growth has resumed in subsequent employment reports.
Wage gains would need to broaden materially over coming months for us to declare a breakout in employee compensation. Such a breakout should not come as a shock when and if it does occur – current levels of unemployment have historically been consistent with unevenly rising employee bargaining power. However, so far the data is too flimsy to make this call. Furthermore, history also tells us that the translation of that higher employee compensation into actual economy wide rising inflation is itself a slow and uneven process. That is not it of course. The recently passed Republican tax cut, allied to the bipartisan deal to raise US government spending, will add a hefty dose of stimulus to an already healthy economy. The combination of declining economic slack and a soaring fiscal deficit could certainly stoke price pressures, but likely further down the line.
Central bankers and bond markets are rightly turning less friendly. Growth is in the process of peaking and a trade war is a few steps closer than it was 3 months ago. These factors have helped to persuade many to retreat from stocks and return to the perceived safety of the bond market. For us, these conditions certainly suggest a more subdued degree of outperformance for stock markets, but outperformance nonetheless. Growth is indeed peaking, but at levels consistent with still strong revenue and earnings growth. Meanwhile, central bankers and bond markets may be getting less friendly, but the current inflation backdrop is certainly not forcing them to become outright hostile just yet. All this, alongside our continuing assumption that protectionist words will not turn into deeds, keeps us moderately positive on the outlook for risk assets over the next 6 – 12 months.